Wednesday, 20 February 2008

The biggest bank heist in history

The Government is to confiscate Northern Rock from its shareholders. This is justified on the grounds that it is only Treasury guarantees and Government lending which keep the business solvent. Northern Rock, the Government claim, was badly managed and pursued a flawed business model. It chose to finance its mortgage portfolio by short term borrowing in the money market rather than by borrowing from depositors. The fact that many banks across Europe do exactly the same and that the European Central Bank has been quietly supporting them through the credit crunch is quietly ignored. The shares in Northern Rock, ministers and their apologists claim, are worthless and the shareholders deserve what they get - nothing.
From the Government’s point of view, the Rock’s liabilities are about equal to the value of its assets. With a net asset value of zero, that should be the end of the matter – the value on the firm’s equity account is zero. Any compensation given to the shareholders would be a sop to wounded pride or a bribe to keep them quiet. But is the Government correct? Is it true the equity in Northern Rock is valueless? Or is this the biggest bank heist in history?
To get some answers to these questions we need to explore the nature of equity in a limited liability company like Northern Rock. It does not take a sophisticated knowledge of finance to appreciate that even though the net assets of a firm might be zero, the value of the shareholders’ claim on the business might be worth considerably more than zero. The reason why this comes about is that the legal right to limited liability confers, in effect, a call option on the underlying assets of the business concerned.
How does this call option work? Simply, if the asset value of the firm drops below the outstanding liabilities the shareholders can ‘hand back the keys’ of the business and walk away. The payoff from their investments is zero. If on the other hand the value of the firm’s assets rise above the value of its debt then the payoff to the shareholders is the difference. As a result, their payoff is either zero, or the difference between the value of the firm’s assets and its liabilities. The value of this implied call option is the price they paid to acquire their shares in the company.
Viewing the equity of Northern Rock for what it is – an option on the underlying assets of the business – casts a different light on how much the shares in the company are now worth. Option value consists of two parts: ‘intrinsic value’ and ‘time value’. The intrinsic value of the equity in Northern Rock is exactly the payoff we have described. With an asset value of about £110bn and outstanding liabilities of the same amount the call option on Northern Rock is ‘at the money’ and as a result the intrinsic value of the equity holders’ option is, as the Government claims, zero.
The second component of option value is less obvious but nonetheless real. This second component is ‘time value’ and for an ‘at the money’ option time value is what matters. The principal drivers of time value are the volatility of returns generated by the firm’s assets, and the time left until the eventual exercise of the option by the shareholders. Generally, the longer an option has to run the greater its value.
When valuing the implied option in a firm’s equity the effective exercise date is the date its liabilities are deemed to mature. With the mix of liabilities in the Northern Rock balance sheet an average period to redemption can be counted in months rather than years. What is not so obvious is that the more volatile the returns on the underlying assets against which the option is written, the greater its time value. This follows from the idea that an option gives the holder the right to ignore downside risk, and take the benefit if the option is ‘in the money’. But, is this fair? Why should shareholders only take the benefit of an increase in their firm’s asset value and ignore any loss? From their point of view, and the law will back them, they have paid their option ‘premium’ and that premium was the price of the equity shares in the market when they bought them.
So how much does this time value work out at? I find it hard to come to a fair value based on time value alone of less than £5.75 per share which is not too dissimilar to the Northern Rock share price in mid September. This reinforces the argument that the collapse in the share price to 90p that followed was not brought about by any sudden revision of the firm’s assets or its liabilities. Northern Rock has been brought down by the mishandled solvency call on the Bank of England and the spectre of nationalisation raised by the government.
Playing the long game, Northern Rock is still a valuable business. The government does not have the protection of limited liability but in all likelihood the bank will recover as the credit markets recover. The Treasury stands to benefit from a windfall of many billions as it refloats the bank on the market – nicely timed of course for the next election. But, make no mistake, the British Government, the Bank of England and the FSA have conspired to bring down a major high street bank. The Government now plans to rip-off the shareholders to the tune of between three and seven billion pounds. If they succeed the government will indeed have got away with the biggest bank robbery in history.

No comments: